Corporation, and Not Shareholders, Actually Entity Operating the Business and Where Loss Had to Be Reported

The question that had to be decided in the case of Barnhart Ranch Co. et al. v. Commissioner, T.C. Memo. 2016-170 was whether the income and deductions from the cattle operations in question was actually the income of the Barnhardt brothers (as they had reported on their 1040s for the year in question) or rather the operations of the corporation.  And, unfortunately for the taxpayers, this is once again a case where the taxpayers, being in charge of the form of a transaction, are not generally going to succeed arguing the substance of the transaction was different.

The brothers had reported net losses from the cattle operation for the years under exam of approximately $860,000 for 2010, $685,000 for 2011 and $970,000 for 2012, using those losses to offset other income reported on their returns.  The IRS contended that those losses rather belonged on the return of BRC, Inc., a C corporation formed by the brothers in September 1994.

The brothers argued that they were the actual owners of the cattle in question and that the corporation either merely functioned to handle the accounting for their cattle operation or that it operated as their agent.  In either case, the cattle activities should be reported on their individual returns in their view.

However, there were some problematical facts.  First was that the employees working in the cattle operation were employees of the corporation.  As the Court noted:

From 2010 to 2012 the cattle operation had 17 employees, and BRC, using ADP Payroll Services, paid these employees. The employees included Sronce, his son Matt, who helped supervise operational activities, and his wife Sharon, who served as an office manager, maintaining financial, operational, production, and employment records. The remaining employees consisted of ranch hands, a housekeeper, and a part-time employee of the Hebbronville ranch who provided security and oversaw the employees working there. BRC filed Forms 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, Forms 943, Employer's Annual Federal Tax Return for Agricultural Employees, and Forms W-3, Transmittal of Wage and Tax Statements, with respect to these employees and issued to them Forms W-2, Wage and Tax Statement.

As well, other significant transactions were undertaken in the name of the corporation, as the Court continues:

BRC held a workers’ compensation and employer's liability insurance policy in its name with respect to the cattle operation employees. It purchased and held farm and ranch insurance in its name that covered both the Westhoff and Hebbronville ranches. It also purchased in its name a buckskin gelding, bought a utility task vehicle equipped with a winch, and held title to several other vehicles.

Finally, the corporation was the recorded buyer and seller for the cattle operation during the years in question:

BRC, as the recorded buyer or the recorded seller, also bought and sold cattle for the cattle operation. These sales and purchases, made at livestock auctions and other venues, occurred under the names “Barnhart Ranch Company”, “Barnhart Ranch Co.”, and “Barnhart Ranch”. In 2010 the cattle operation sold about 600 cattle, in 2011 it sold about 1,500, and in 2012 it sold about 800.

Generally, the funds from any cattle sales would be deposited into the corporation’s account and accounted for as a payable in ½ of that amount for each brother.  The corporation would pay any expenses from those funds, including both business related expenses and personal expenses.  The corporation would then issue the brothers a check if the income exceeded the expenses for that month.  Because it emptied out is bank account under this procedure, the brothers from time to time had to advance the corporation funds to pay bills.

The Tax Court first looked at the “accounting services” entity view of BRC and rejected it.  The Court noted:

It is unclear from testimony and other evidence what petitioners mean when they describe BRC as an “accounting agent”, i.e., whether they are attesting that BRC actually performed the joint interest billing for the cattle operation or whether it was used simply as a strawman to provide a temporary repository for the operation’s income and expenses to accomplish joint interest billing. Other than self-serving testimony—which we need not and do not accept, see Tokarski v. Commissioner, 87 T.C. 74, 77 (1986)—the evidence does not show that BRC actually provided accounting services. (Borowski, the only accountant that testified about BRC’s accounting practices, appeared to be an employee of Barnhart Interests, Inc., or, less likely, Barnhart Co.) To the contrary BRC appears to have been charged for receiving accounting services.

The court noted, as well, that even if it had been performing accounting services that would be merely one part of the business purpose of managing the cattle operation, the activity that the corporation showed as is its business activity on its 2012 and 2013 federal income tax returns.

The Court also found that BRC was the owner of the cattle in question, noting:

It deposited all income from the cattle sales into its BRC account, directly paid cattle operation expenses from that account, and even exercised its power of ownership over the funds by directing payment of the excess thereof to its stockholders—all recognizable economic benefits.

As well, the Court noted that BRC was held out to the public as the owner of the cattle, specifically indicating that to livestock auctions, brokers, buyers, sellers and vendors.  The Court found no evidence the brothers ever sought to advise other parties that BRC wasn’t the actual owner of the cattle.

The Court also found there was no evidence that an agency relationship existed.

The Court closes by noting:

On brief petitioners recognize that they “could have transferred the cattle business to an S corporation or a limited partnership with the same tax result”, and in reality they have realized this goal with the McDermott-Barnhart Partnership. For whatever reasons, however, the Barnhart brothers chose to run BRC not as a flowthrough entity but as a corporation. Petitioners “cannot now escape the tax consequences of that choice, no matter how bona fide * * * [their] motives or longstanding * * * [their] arrangements.” Nat'l Carbide Corp. v. Commissioner, 336 U.S. at 438-439. We sustain respondent's adjustments to the returns of petitioner and Karol Ann Barnhart and Irvin Barnhart for their respective tax years in issue, in which they inappropriately reported income and expenses and the resulting net losses of BRC.